A comprehensive risk appetite framework for banks

by
Philipp Wackerbeck, Paul Hyde, Thorsten Liebert

Originally published by Booz & Company: September 30, 2009

What is risk appetite and why does it matter now?

Definition and objective of risk appetite

The global financial crisis has demonstrated clearly that many banks lacked a proper understanding of their true risk profile and realized too late that it was not in line with their desired risk profile. This forced senior management to explain losses that were a multiple of what shareholders had expected to face. The key lesson learned from this crisis is that financial institutions need to have a comprehensive risk appetite framework in place that helps them better understand and manage their risks by translating risk metrics and methods into strategic decisions, reporting, and day-to-day business decisions.

Risk appetite is considerably more than a sophisticated key performance indicator (KPI) system for risk management. It’s the core instrument for better aligning overall corporate strategy, capital allocation, and risk. Regulators, rating agencies, and professional investors are aggressively pushing banks to advance their risk management practices. A comprehensive risk appetite framework is the cornerstone of a new risk management architecture.

A comprehensive risk appetite framework is embedded in the corporate strategy and risk culture of the bank

1. Stakeholder objectives

Regulators and rating agencies now require banks to align various stakeholder objectives to better balance strategy, capital, and risk

2. Corporate level

High-level KPIs are defined and operationalized, with risk appetite and tolerances established for each

2. Corporate level

The desired risk appetite helps facilitate business portfolio decisions based on a comparison of risk/return profiles

2. Corporate level

For specific risk management purposes, risk appetite and tolerances are defined for all major risk categories

3. Business unit and department/product level

Corporate-level risk appetite and tolerances are drilled down to business units with limits and targets for departments and products

4. Capabilities

Specific capabilities are required to successfully implement and manage a risk appetite framework

5. Risk appetite process

Once the risk appetite is set, it needs to be embedded, and then continuously monitored and revised

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